As an investor, navigating the nuances of the investment industry can be quite challenging especially as human emotions, such as the fear of missing out, are often involved. It isn’t surprising, then, that the sole criteria when selecting an investment often ends up being its one- or two-year return.

Exchange-traded fund (ETF) providers and mutual fund managers know this all too well and therefore incubate new funds based on the market’s flavour of the month, and then excessively promote those that have delivered strong near-term returns. Investment advisors, many of whom are still compensated for selling specific financial products, also know that those in the spotlight sell particularly well.

In today’s market environment, the hot sectors include marijuana, robotics, automation and artificial intelligence, cryptocurrencies and even certain segments of the U.S. market, such as the FAANG (Facebook, Apple, Amazon, Netflix and Alphabet’s Google) stocks, which have been the primary drivers of the S&P 500’s recent returns. While these are extreme examples, other lesser versions of the same pattern exist — such as the recent exodus of money out of Canadian focused funds towards international funds given the large return variance last year.

As an outsourced chief investment officer (OCIO) we prefer a more conservative balanced approach which takes away some of the speculative return-chasing from the investment process. This includes utilizing a combination of globally diversified ETFs; active long-only managers focusing on delivering alpha; risk-managed and alternative sectors including those who utilize pair trades, arbitrage, option overlays; and finally direct investment, private equity and venture capital.

We’ve learned over the years that when selecting investment managers, including both long-only alpha generators and specialized alternative managers, there are three key factors to look for if you are more interested in the fundamentals and strategic portfolio fit instead of simple near-term performance.

Leadership

It is helpful to look for a team that is cohesive in their approach and culture especially among the independent investment firms. Having skin in the game is paramount as most of the dysfunctional firms we’ve come across have succession issues, with highly concentrated ownership among a few individuals. As a result there can be a high turn-over rate which makes it difficult to deliver consistency in their return profile.

Investment Process

A firm’s investment process determines the value they are adding above and beyond a comparable passive strategy. If the process is overly complicated and can’t be explained in a way that one can easily understand, then you should probably stay away. In addition, it is important to recognize that there are times when a firm’s investment process and strategy will be out of favour and the key is that they do not capitulate. This could include a value manager suddenly shifting their holdings to high-growth names.

By focusing on managers who are best-in-class in their respective fields of expertise, it adds an additional layer of diversification to the entire portfolio. Therefore, despite being contrary to human nature, it is prudent to rebalance periodically moving money from those managers whose strategies are outperforming to those who are out of favor and underperforming.

Risk-Management

The last component is understanding the level of risk undertaken to generate the returns. There are some firms that try and cheat by utilizing leverage or concentrating their positions so it helps to take a look at the underlying holdings within each fund and comparing them to the offering memorandum or prospectus before investing.

For those with a long enough track record, review how they performed during market corrections, which would be reflected in their drawdowns. Those with risk-managed practices will have protected capital losses compared to passive benchmarks over these periods.

Finally, while cost is an important factor it also shouldn’t be an exclusive one as it is worth paying up for a good manager who will show their merit during periods of excess volatility. That said, in our opinion, this shouldn’t be more than 1.0 per cent for a long-only manager and 1.5 per cent for a specialty manager, and 2.0 per cent for venture cap and private equity.

Martin Pelletier, CFA is a Portfolio Manager and OCIO at TriVest Wealth Counsel Ltd, a Calgary-based private client and institutional investment firm specializing in discretionary risk-managed portfolios as well as investment audit and oversight services.